Let There Be Growth, and/or Inflation

Ezra Klein, an online columnist for the Washington Post, has been a sympathetic chronicler of President Barack Obama’s efforts to combat the Great Recession and its messy aftermath. So, of course, in his 4,500-word New York Review of Books article on Ron Suskind’s Confidence Men—a gossipy account of the trials and tribulations of the administration’s economic team—he managed to locate the “real cause” of “Obama’s flunking economy” not at the White House or the Treasury Department but rather with recalcitrant Republicans and at the chairman’s desk inside the grandiloquent limestone precincts of the Federal Reserve Board’s headquarters in Washington, D.C.

The great personnel mistake of the president’s first term, according to Klein, was the reappointment of Benjamin Bernanke as Fed chairman in 2010. Although Klein praises Bernanke for taking extraordinary short-term measures to prevent a second Great Depression in 2008 and 2009, he tasks the Bernanke Fed with failing to do everything possible to boost growth and job creation: “If [the White House] had managed to install a more activist chairman at the Federal Reserve, then its inaction might have been more effectively offset by the Fed’s actions.”

Klein’s argument reflects a key recent piece of liberal economic orthodoxy in the wake of the failed efforts to boost the U.S. economy over the past three years: the need for the Fed to undertake a massive and unprecedented monetary stimulus to kick-start the U.S. engine and avoid a Japanese-style Lost Decade. “Desperate times call for bold measures,” former Obama economic adviser Christina Romer pleaded in an October New York Times op-ed. “Paul Volcker understood this in 1979. Franklin D. Roosevelt understood it in 1933. This is Ben Bernanke’s moment. He needs to seize it.”

It would all begin with a mere utterance from Bernanke: “Let there be growth.” What Klein, Romer, Krugman, and the investment bank Goldman Sachs specifically want Bernanke to do is announce that the Fed would stop unofficially attempting to keep the inflation rate at 2 percent or so and start explicitly targeting “nominal GDP.” That term refers to the economy’s total output of goods and services—not adjusted for inflation. Since 1990, nominal GDP has been running around 5 percent annually, made up of 3 percentage points of actual growth plus 2 percentage points from inflation.

For the past two years, however, nominal GDP has run around 4 percent—2 percent from growth and 2 percent from inflation. Supporters of the idea that the Fed should target nominal GDP want it to aim for 5 percent or more. They don’t care what amount is attributable to growth and what amount is attributable to inflation—they just want the overall 5 percent number to be hit. Real growth could be 4 percent and inflation 1 percent. Or real growth could be 1 percent and inflation 4 percent. But either way, the Fed would be shooting for 5-percent nominal GDP growth. In the near term, the NGDP growth rate would have to be even higher than 5 percent to erase the output gap since 2007 when NGDP has annually grown less than 5 percent. And that probably means even more inflation.

The idea is that Bernanke would declare that the Fed is looking for a 5-percent nominal GDP rate. Which would mean that if the economy doesn’t produce real growth, the Fed will supplement it with inflation. The thinking is that simply announcing a 5-percent nominal GDP target might be enough to change consumer and business expectations and actions, since Bernanke has demonstrated the Fed’s willingness to run the printing presses at full speed with his two “quantitative easing exercises” in 2007 and 2010. One proponent of this strategy offers a colorful and interesting analogy: If Chuck Norris walks into a crowded room and says he will start beating people up until the room is empty, the room will probably clear with no actual punches thrown. The threat is action enough.

How would this help the economy? Another way of looking at nominal GDP is as a measure of the economy’s aggregate demand. If businesses knew with certainty that there was a floor of 5 percent on that demand, they could plan accordingly. By guaranteeing a stable demand trajectory in the future, consumers and businesses would theoretically be more likely to spend and invest today.

Under an NGDP-targeting regime, the U.S. economy would, in theory, be rid of the possibility of a year like 2009, when real GDP growth fell by 3.5 percent. The Fed would instead promise to do whatever it takes to crank up NGDP, even if that entailed a rate of inflation approaching double digits. And with the prospect of higher inflation due to the clearly announced nominal GDP target, consumers and businesses would also have another reason to spend and invest today rather than hold cash that will lose value tomorrow.

To a great extent, nominal GDP-targeting is a way of avoiding John Maynard Keynes’s famous “paradox of thrift,” which explains that saving rises during an economic downturn just at the moment when what the economy needs is spending now, frugality later. But wouldn’t consumers and businesses worry that inflation might get out of control? Maybe not, targeting proponents say. In addition to the Fed’s credible anti-inflation record—we’ve had 30 years of startlingly low inflation due to the visionary anti-Keynesian efforts of Paul Volcker in 1981 and 1982—the focus on targeting nominal GDP rather than on inflating currency would make it less obvious that the Fed was steering the economy by running the printing presses. Paul Krugman praises nominal GDP-targeting explicitly: “[It’s] a more acceptable way to justify…a de facto higher inflation target. Don’t call it a deception, call it a communications strategy.”

The key selling point isn’t one of stealth but of simplicity, which is one reason NGDP-targeting also appeals to some conservatives, most notably Ramesh Ponnuru of National Review. It’s a way of doing something to secure economic growth that circumvents the stalemate between Republicans and Democrats. Fiscal policy seems at a standstill in Washington, as reflected in the failure of the congressional “supercommittee” to achieve any debt reduction, much less its mandated $1.2 trillion in cuts.

Neither party accepts the other’s approach toward boosting economic growth. Democrats think cutting spending and taxes merely leads to more austerity and income inequality. Republicans think more government spending will merely accelerate the country’s appointment with its destiny of an EU-style debt crisis. Maybe after the next presidential election, Congress will be able to strike a grand bargain on entitlement and pro-growth tax reform. But that could mean another two years or more of sky-high unemployment and debt, both crises in their own respect.

So, instead of lobbying 535 members of Congress for a change of policy direction, you just need to convince Ben Bernanke to utter a few sentences at his next press conference—and your fears of a Lost Decade may vanish. Indeed, Goldman Sachs thinks a nominal GDP-targeting strategy would lower the unemployment rate to around 6 percent by 2016. Without one, it projects 7 percent that year and beyond.

And there’s the rub. The idea of nominal GDP-targeting would threaten the Fed’s hard-fought credibility as an inflation-killer and raise expectations of future inflation simply to jimmy the unemployment rate a point or so lower than it would be five years from now. Is that worth it?

Even Goldman Sachs admits that its forecast is “critically” dependent on the public’s believing that the Fed can (a) hit its GDP output target and (b) keep inflation in check once the target has been met. Yet this is the same American public that saw the bank play a critical role in the onset of the financial crisis by keeping interest rates too low for too long. And more recently, the Fed’s two rounds of quantitative easing don’t seem to have done much for either GDP growth or unemployment. To the extent that Americans have an opinion of him, Bernanke is a distrusted figure.

And so it turns out that even supporters of nominal GDP-targeting don’t think it can work in isolation. Goldman Sachs and other advocates believe the Fed needs to combine a targeting regime with a third round of quantitative easing, buying up bank bonds and thereby doubling the amount of money in the hands of banks to more than $5 trillion. With that added firepower backing up an explicit nominal GDP target, Goldman thinks the unemployment rate would drop to 6 percent in 2015, a year earlier than with the target alone.

That is, of course, unless markets begin to worry that the Fed won’t be able to unwind its positions in a timely manner to prevent an uncontrolled inflation surge. If that were to happen, Goldman Sachs acknowledges, interest rates would rise and decelerate economic growth and job creation. We would end up in a condition worse than the one we are in now.

That concern is well justified, according to R. Glenn Hubbard, dean of Columbia’s business school and potential Fed chairman if a Republican wins the White House in 2012. As he told me recently: “In the near term, it’s hard for me to imagine that [NGDP-targeting] would work much differently than what the Fed is currently doing, which isn’t exactly a booming success. And then in the longer term, I would worry about inflationary expectations becoming unhinged….What makes me nervous is anything that looks like temporary increases in inflation, because our experience is, that’s a genie that’s very hard to put back in the bottle.”

House Budget Committee chairman Paul Ryan puts it this way: “They think they can steer the car between the pylons going at a 110 miles an hour—and they can mop up any inflation at just the right point when it gets just a little too high. As if they can keep inflation to single digits because they can just fine tune the economy on a dime.”

The fear, then, is that Bernanke would declare, “Let there be growth,” but what he would really be doing is announcing, “Let there be inflation.” This latest round of monetary stimulus might be merely a reckless economic experiment that would risk unleashing the demon Volcker caged only three decades ago.

But NGDP proponents on the right insist that concerns about runaway inflation are overdone, especially with the U.S. unemployment rate stuck at twice that of the pre–Great Recession level and likely to stay elevated for years in the absence of much faster economic growth. At the same time, inflation seems benign. Overall consumer prices increased by 3.5 percent in the 12 months before October. But the Fed pays closer attention to so-called core prices—excluding volatile food and energy—which climbed 2.1 percent from October 2010. Team Bernanke aims for long-run overall inflation of 1.7 percent to 2 percent. Therefore, argue Ponnuru and the economist David Beckworth, in an article in the New Republic, fretting about inflation is a “foolish fear.” They note that despite all the Fed’s potentially inflationary actions in recent years, the market for inflation-indexed bonds suggests that investors expect it to stay that way for years to come.

Perhaps, but when you listen to what some advocates of nominal GDP-targeting want to do to meet that goal, it’s easy to see how things could get out of hand. Romer suggests the Fed “do whatever it takes, including QE3, more forceful promises about short-term interest rates, and perhaps moves to lower the exchange rate.” Liberal economist Brad DeLong has his own suggestions: “The government can buy more than Treasuries….And if that doesn’t work, you buy bank and corporate debt. And if that doesn’t work, you lend JPMorgan Chase $30 billion on the security of [its chairman] Jamie Dimon’s dog. And if that doesn’t work, you buy equities.” Anything, in other words, to pump greenbacks into the economy. Anything.

It is therefore little wonder that Bernanke himself has been lukewarm at best about the idea, recently telling reporters that he does not expect the Fed “to move to an NGDP target anytime soon, although the probability would increase if growth and/or inflation slowed by more than we currently estimate.” Bernanke knows such a change would further put the bank in the crosshairs of congressional Republicans. That’s a group, who, even if they don’t want to “end the Fed” as does the libertarian extremist Ron Paul, certainly wish to subject it to more oversight. Bernanke must also surely realize that more monetary stimulus would decrease the pressure on Congress to move decisively on a fiscal reform that would actually address the nation’s long-term debt crisis.

But another Fed chairman might be more willing to roll the dice, which is why liberals see Bernanke’s 2009 reappointment as, at best, a missed opportunity and, at worst, a blunder that has sentenced the U.S. economy to years of subpar growth and above-average unemployment. It’s also why they see a second Obama term as essential: A second Obama term would provide a chance to correct the Bernanke “mistake.” And should that happen—as far as the federal government’s adopting a strategy to establish a benchmark size for the U.S. economy—Katie, bar the door. And Katie, start buying gold.

About the Author

James Pethokoukis, who has held editorial positions at U.S. News and World Report and Reuters, is now a columnist and blogger at the American Enterprise Institute.